Debt and APR: reading the cost of a loan
The nominal rate and the annual percentage rate do not say the same thing. How to compare loans and why expensive debt comes before investing.
Nominal rate and APR are not synonyms
The nominal interest rate is the pure interest applied to the sum borrowed. It does not include other charges. The annual percentage rate, or APR, expresses the overall cost of the loan on a yearly basis: on top of interest it adds arrangement fees, payment collection charges, taxes and any insurance that is compulsory to obtain the credit.
To compare two offers, the number to look at is the APR. A loan advertised with a very low nominal rate, or even "zero interest", can have a noticeably higher APR because of the charges. Consumer credit rules in the European Union and the United Kingdom require the APR to be shown in advertising that quotes rates or figures and in pre-contract information.
The other things to look at
Besides the rate, the term and the total amount payable matter, that is, the sum of all the instalments. Lengthening the term lowers the monthly payment but increases the total interest paid: a "comfortable" instalment is not necessarily a good-value loan.
It is also worth reading the early repayment conditions, the charges for late payment and whether the rate is fixed or variable: with a variable rate the instalment can rise if market rates rise. Revolving credit on cards generally carries some of the highest rates on the market.
Debt and investing
There is a simple comparison that financial education materials often make. Paying off a debt on which you pay a given rate is, in economic terms, like earning that rate with certainty and without risk. That is why, when faced with high-rate debt, reducing it usually comes before any investment, whose result is uncertain.
Low-rate, long-term debts such as many home mortgages are a different matter: there the assessment depends on the overall situation and has no single answer.
When debt becomes a problem
A practical indicator is the ratio between total monthly repayments and net income. When repayments absorb a significant share of income, the room for the unexpected shrinks and the risk grows of having to take out new loans to pay the old ones.
If you find yourself in this situation, the first step is to talk to the lender early, before missing a payment: renegotiation options often exist. Many countries also offer free, impartial debt advice services run or endorsed by public bodies. What to avoid is anyone promising to wipe out your debts in exchange for an upfront payment.
Educational and informational content only. It is not personalised financial, investment or tax advice. All investments involve risks, including the possible loss of invested capital.
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